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Tax-Loss Harvesting with ETFs

Key Points

The "wash sale" rule means you can't take a taxable loss on a security if you buy it back within 30 days.

Buying an ETF that's similar to the sold investment might make sense.

Exchange-traded funds (ETFs) have a reputation for tax efficiency, in large part because stock ETFs rarely make capital gains distributions. But ETFs can also help on the tax front via tax-loss harvesting—when securities that have dropped in value are sold in order to offset other capital gains (and even some ordinary income) at tax time.

ETFs can help you target exposure to a particular investing niche (for example, an individual country or industry) or they can help you to diversify (for example, by offering exposure to a broad market index). This versatility, combined with many ETFs' liquidity, makes them well-suited to potential tax-loss harvesting while avoiding wash sales.

First, let's take a closer look at tax-loss harvesting.

What is tax-loss harvesting?

Tax-loss harvesting refers to the practice of selling securities in a taxable account that have dropped in value in order to "harvest" a capital loss for tax purposes. For instance, you might have stock in XYZ Corp that you purchased for $10,000 a year ago, but it's only worth $8,000 today. If you sell that stock, you'll realize a $2,000 capital loss. This loss can be used to offset capital gains in your portfolio that you've realized from selling other securities that appreciated in price while you owned them. If you hadn't harvested the $2,000 loss, your taxes this year would be higher. The loss helps to offset the gain.

When it comes to tax-loss harvesting, it's important to keep a few things in mind:

It only works if you're harvesting the loss in a taxable account; selling securities at a loss inside an IRA doesn't help with your taxes (just as it doesn't hurt if you sell securities at a gain inside an IRA).

You might not really want to sell the securities in which you're realizing the loss; you might still think they're a good investment for the long term. But if you buy them back within 30 days (or buy a "substantially identical" security), the IRS considers it a "wash sale" and disallows the loss offset for tax purposes.

Tax-loss harvesting won't necessarily reduce the total amount of taxes owed over time. If you eventually re-purchase the securities you sold, they’ll have a lower tax basis now than when you initially invested. Selling them at a higher price in the future would result in a taxable gain.

Using ETFs to avoid wash sales

So what do you do if you think the security you sold is a good long-term investment but you still want to harvest the unrealized loss? This is where ETFs can help.

Let's say XYZ Corp is a company in the Financials sector. Perhaps you like its long-term prospects. You don't want to sell the $8,000 worth of stock and just leave it sitting in cash for 31 days while you wait for the wash-sale period to end; you're worried that this will be the time the stock finally rallies.

One strategy to consider would be to put the $8,000 to work in an ETF that's similar to the stock you sold—but not "substantially identical," so you don't run the risk of a wash sale. A great example is an ETF that tracks the Financials sector. If XYZ Corp performs well over the next 31 days, it's possible the entire Financials sector will also perform well. You might be able to capture some of the stock's movement by holding a basket of stocks in its sector. You'll have more diversification than if you'd simply bought the stock of a different financials company, but you're still exposed to the sector that's likely to go up if XYZ Corp increases in value.

You could even consider getting more focused on the industry that XYZ Corp is in (such as banking) by buying an ETF that only tracks that industry. The industry ETF is likely to move even more closely in line with the stock than the broader sector ETF.

Similar logic can apply if you have stock in a foreign company and you choose to sell it and put the proceeds into an ETF that tracks the country in which that stock is based.

Some investors looking for low-cost ETFs to temporarily replace securities in their portfolios for tax loss harvesting consider the funds on the Schwab ETF Select List®.

Selling mutual funds? ETFs? The same principles can apply.

You may also have mutual funds or ETFs that have fallen in value, in which case another ETF might be a good place to put the proceeds of the tax-loss harvest during the 30-day wash-sale period. Be careful to ensure that the ETF you buy during the wash-sale period isn't "substantially identical" to the fund that you've sold.

The IRS has not provided firm guidance on exactly what "substantially identical" means for funds and ETFs. So it's best to assume, for instance, that selling an index mutual fund that tracks the S&P 500® Index and putting the proceeds into an ETF that tracks the same index could leave you at risk of having the transaction deemed as a wash sale, and therefore have the loss offset disallowed for tax purposes.

Tax caveat: What happens if the ETF goes up in value?

The whole point of putting the proceeds from your tax-loss harvest sale into an ETF that's similar (but not "substantially identical") to the investment you sold is to not lose out on any gains in the harvested investment during the wash-sale period. So what happens if there are gains in the ETF while you hold it?

Well, if the ETF in which you invested the proceeds increases in value during the next 30 days and you then sell it to put the money back into the original investment, you'll have realized a short-term capital gain in the ETF itself. Now, depending on the timing of the switch, you might be realizing that gain in the next calendar year, which means you likely won't owe any taxes on it for a while.

Still, there is the chance that harvesting your loss for tax purposes and putting the money into an ETF could end up leaving you with a sizable taxable gain when you switch back into the original investment. That's not the end of the world, of course—it means you've made money! But it's an important possibility to acknowledge.

The bottom line: ETFs may be a good choice

If you have unrealized capital losses in your portfolio, it might be a good idea to realize those losses to save some money on your taxes. If you don't want that money sitting in cash while you wait for the 30-day wash sale period to pass, you might be able to find an ETF that's a good place for your money in the meantime.

Investors should consider carefully information contained in the prospectus, or, if available, summary prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice, either under the Investment Advisers Act of 1940, or the Department of Labor's Fiduciary Rule. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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